Monday Mailbag: Tops and Bottoms
Short sellers love to target stocks that are breaking down after long uptrends. On the flip side, long-minded traders want to find stocks that are showing signs of life after prolonged downtrends.
Accurately pinpointing tops and bottoms can lead you to explosive gains. That’s why Jonas and I have dedicated a lot of space in these columns to discussing various topping and bottoming patterns in stocks — and how you can take advantage of the respective breakdowns and breakouts.
To follow up on these conversations, I will be answering a couple of your best questions on this topic today.
Let’s get started:
“How close must two bottoms be to be considered a ‘double bottom’? Within 1%? Within 5%?”
Let’s begin with some advice that’s important not only for double bottoms, but any chart pattern you might be scanning: Aside from a couple of key basic characteristics, there’s no hard-and-fast rule regarding what a proper double bottom will look like.
It’s true — identifying proper bottoms would be a lot easier if we had some numerical guidelines like this reader suggested. We could simply rule out certain setups based on a “1% rule” and place our trades. But chart patterns usually require a little give-and-take. I always say there is a certain artistry to identifying potentially profitable patterns. And with any subjective science, three separate technicians might see three very different signals on any given chart.
That being said, here are a few guidelines I use when looking for double bottoms:
- Two distinct, separate bottoms at similar levels
- A clear, identifiable resistance zone
- The second bottom shouldn’t dip lower than the first bottom.
Here’s a decent example a reader asked about last week:
Notice how the second bottom is bought at higher levels than the first. That’s a great sign — it shows us that buyers are stepping in earlier to support this stock.
But even if there are some irregularities in the actual bottoms, your main focus should always be resistance. After all, you won’t even trade this pattern unless it clears the resistance level. There are many imperfect bottoming patterns out there. Not all of them are flawless double bottoms or rounding bottoms. Once you feel as if you’ve developed the instinct, you need to spot the nuances of each of these patterns. You can begin to explore some less traditional setups in your trading…
“The U.S. dollar shows a head-and-shoulders pattern. Your comments?”
You won’t hear any argument from me about this. The U.S. dollar didn’t even come close to its July highs during its most recent rally, which appears to have ended last month, setting up the right shoulder in a bearish looking head-and-shoulders pattern. It’s very possible this chart is topping out. Here’s a weekly view:
The neckline looks to be right at 79 on the weekly chart. This is where you should watch for the dollar to break down. And if we do see a meaningful move below 79, the consequences for the dollar are pretty grim…
Typically, a downside price target for a head and shoulders is equal to the highest point of the pattern measured from the neckline (84 in this case). That gives us a downside target of 74 for the dollar index after a move below 79.
One more thing: Look at how this downside target lines up perfectly with support near the dollar’s 2011 lows. This level would also mark a 100% retracement of the 2011-2012 rally. When you begin to see all of these technical factors line up, a long-term target of 74 appears even more likely for the U.S. dollar index.
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